Introduction to Entrepreneurship and Innovation

Eng. Hadeel Alomari

Fall 2022/2023

CHAPTER 8
Assessing a New Venture’s Financial Strength and
Viability
Copyright © 2016, 2012, 2010 Pearson Education, Inc. All Rights Reserved.
 Financial Management (1 of 2)

Financial Management
◦ Financial management deals with two things: raising money and
managing a company’s finances in a way that achieves the highest
rate of return.

– Chapter 10 focuses on raising money. This chapter focuses primarily

on:
 How a new venture tracks its financial progress through preparing, analyzing,
and maintaining past financial statements.
 How a new venture forecasts future income and expenses by preparing pro
forma (or projected) financial statements.
 Financial Management (2 of 2)
The financial management of a firm deals with questions such as the following
on an ongoing basis:

Profitability •How are we doing? Are we making or losing money?

Liquidity •How much cash do we have on hand?
•Do we have enough cash to meet our short-term obligations?
Efficiency •How efficiently are we utilizing our assets?
•How do our growth and net profits compare to those of our industry peers?
•Where will the funds we need for capital improvements come from?
Stability •Are there ways we can partner with other firms to share risk and reduce the amount of cash we
need?
•Overall, are we in good shape financially?
Financial Objectives of a Firm
Primary Financial Objectives of Entrepreneurial Firms
 Financial Objectives of a Firm (1 of 4)

1. Profitability
◦ Is the ability to earn a profit.
◦ Many start-ups are not profitable during their
first one to three years while they are
training employees and building their
brands.
◦ However, a firm must become profitable to
remain viable and provide a return to its
owners.
 Financial Objectives of a Firm (2 of 4)
2. Liquidity
◦ Is a company’s ability to meet its short-term financial obligations.
◦ Even if a firm is profitable, it is often a challenge to keep enough
money in the bank to meet its routine obligations in a timely
manner.
To do so, a firm must keep a close watch on accounts receivable and inventories.

A firm’s accounts receivable is money owed to a firm by its customers.

Its inventory is a firm’s merchandise, raw materials, and products waiting to be sold.

If a firm allows the levels of either of these assets to get too high, it may not be able to keep enough
cash on hand to meet its short-term obligations.

is a firm's financial obligations that are expected to

be paid off within a year.
 Financial Objectives of a Firm (3 of 4)
3. Efficiency
◦ Is how productively a firm utilizes its assets relative to its revenue and its
profits.
◦ Southwest Airlines, for example, uses its assets very productively. Its
turnaround time, or the time its airplanes sit on the ground while they
are being unloaded and reloaded, is the lowest in the airline industry.
 Financial Objectives of a Firm (4 of 4)

4. Stability
◦ Is the strength and vigor of the firm’s overall financial posture.
◦ For a firm to be stable, it must not only earn a profit and remain liquid
but also keep its debt in check.
If a firm continues to borrow from its lenders and its debt-to-
equity ratio gets too high, it may have trouble meeting its
obligations and securing the level of financing needed to fuel its
growth.

Debt-to-equity is calculated by dividing its long-term debt by its

shareholders’ equity
The Process of Financial What is the purpose of analyzing financial statements
Or
Management (1 of 4) Explain the importance of financial statements to an
entrepreneurial firm

Importance of Financial Statements

◦ To assess whether its financial objectives are being met, firms
rely heavily on analysis of financial statements.
◦ A financial statement is a written report that quantitatively
describes a firm’s financial health.
◦ The income statement, the balance sheet, and the statement of
cash flows are the financial statements entrepreneurs use most
commonly.
 The Process of Financial
Management (2 of 4)
Forecasts
◦ Are an estimate of a firm’s future income and expenses,
◦ Existing firms base their forecasts on past performance, its current
circumstances, and its future plans.
◦ New ventures typically base their forecasts on an estimate of sales and
then on industry averages or the experiences of similar start-ups
regarding the cost of goods sold and other expenses.

Budgets
◦ Are itemized forecasts of a company’s income, expenses, and capital
needs and are also an important tool for financial planning and control.
 The Process of Financial
Management (3 of 4)
Financial Ratios
◦ Depict relationships between items on a firm’s financial statements.
◦ An analysis of its financial ratios helps a firm determine whether it is meeting
its financial objectives and how it stacks up against industry peers.
What is the purpose of analyzing financial ratios
Or
Explain the importance of financial ratios analysis to
an entrepreneurial firm
Importance of Financial Management
◦ Many experienced entrepreneurs stress the importance of keeping on top of
the financial management of the firm.
 Management process for…
The Process of
Existing firms Start-ups
Financial
Management

Assumptions sheet Assumptions sheet

• past performance, • estimate of sales
• its current • industry averages
circumstances, • or the experiences of
• and its future plans. similar start-ups

Ratio analysis Should be

applied after preparation of
historic financial statements
too

Copyright © 2016, 2012, 2010 Pearson Education, Inc. All Rights Reserved.
Financial Statements

Historical Financial Statements

◦ Reflect past performance and are usually prepared on a quarterly and annual
basis.
◦ Publicly traded firms are required by the SEC to prepare financial statements
and make them available to the public.

Pro Forma Financial Statements

◦ Are projections for future periods based on forecasts and are typically
completed for two to three years in the future.
◦ Pro forma financial statements are strictly planning tools and are not
required by the SEC.
 Historical Financial Statements

Three types of historical financial statements

Financial Statement Purpose
Income Statement Reflects the results of the operations of a firm over a
specified period of time. It records all the revenues and
expenses for the given period and shows whether the firm
is making a profit or is experiencing a loss.

Balance Sheet Is a snapshot of a company’s assets, liabilities, and

owner’s equity at a specific point in time.
Statement of cash flows Summarizes the changes in a firm’s cash position for a
specified period of time and details why the changes
occurred.
Print this out
while studying
and keep it
nearby when you
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read other slides (‫)أ@نشطة ا@@لشركة‬

Make sure you ‫نفقات‬ ‫استثمار‬

understand each (‫)مثلش@@راء أ@جه@زة ج@ديدة‬
word in it ‫أرباح‬ ‫التزامات‬ ‫تمويل‬
(‫)مثلا@@لحصولعلىق@@رض‬

“current” refers to a time period of

one year or less. Current assets are
available within 12 months; current ‫أسهم‬
liabilities are due within 12 months.

https://www.sketchbubble.com/en/
presentation-financial-statements.html
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 New Venture Fitness Drinks

New Venture Fitness Drinks

◦ To illustrate how financial statements are prepared, we used New Venture Fitness
Drinks, the fictitious sports drink company introduced in Chapter 3.
◦ New Venture Fitness Drinks has been in business for five years.
◦ Targeting sports enthusiasts, the company sells a line of nutritional fitness drinks.
◦ It opened a single location in 2016, added a second location in 2018, and plans to add a
third in 2019.
◦ The company’s strategy is to place small restaurants, similar to smoothie restaurants,
near large outdoor sports complexes.
◦ The company is profitable and is growing at a rate of 25 percent per year.
Historical Income Statements
Table 8.1 Consolidated Income Statements for New Venture Fitness Drinks, Inc.
Blank December 31, 2018 December 31, 2017 December 31, 2016
Net sales $586,600 $463,100 $368,900
Cost of sales 268,900 225,500 201,500
Gross profit 317,700 237,600 167,400
Operating expenses blank blank blank
Selling, general, and administrative 117,800 104,700 90,200
expenses
Depreciation 13,500 5,900 5,100
Operating income 186,400 127,000 72,100
Other income blank blank blank
Interest income 1,900 800 1,100
Interest expense (15,000) (6,900) (6,400)
Other income (expense), net 10,900 (1,300) 1,200
Income before income taxes 184,200 119,600 68,000
Income tax expense 53,200 36,600 18,000
Net income 131,000 83,000 50,000
Earnings per share 1.31 0.83 0.50
1. Income Statement: Reflects the results of the operations of a firm over a specified period of time. It records all
the revenues and expenses for the given period and shows whether the firm is making a profit or is experiencing a
loss.
Dec 31, 2018 Dec 31, 2017 Dec 31, 2016
Net sales 586,600 463,100 368,900
Cost of sales 268,900 225,500 201,500
Net sales – Costs sales Gross profit 317,700 237,600 167,400
Operating expenses 131,300 110,600 95,300
Gross profit – Operating expenses Operating income 186,400 127,000 72,100
Interest 2,200 8,000 4,000
Taxes 53,200 36,000 18,000
Operating income – (interest & taxes) Net income 131,000 83,000 50,000

Operating margin: operating income(profit before taxes and interest)/net sales (revenues)
• Are the company’s sales increasing?
• Is it profitable?
• Is the net income increasing?
• Is the company increasing or decreasing its material and labor costs per dollar of sales?

18
• One thing that is of a particular importance when evaluating a firm’s income
statements is a firm’s profit margin, or return on sales, which is computed by
dividing net income by net sales.

• A firm’s profit margin tells what percentage of every dollar in sales contributes to
the bottom line:
o An increasing profit margin means that a firm is either boosting its sales
without increasing its expenses or that it is doing a better job of controlling its
costs.
o In contrast, a declining profit margin means that a firm is losing control of its
costs or that it is slashing prices to maintain or increase sales.

You try:
Refer to the income statement in the previous slide. Calculate the profit margin or return on sales for each
year. Is the profit margin increasing or decreasing and why?

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19
Copyright © 2016, 2012, 2010 Pearson Education, Inc. All Rights Reserved.
Historical Balance Sheets (1 of 2)
Assets
Table 8.2 Consolidated Balance Sheets for New Venture Fitness Drinks, Inc.
Assets December 31, 2018 December 31, 2017 December 31, 2016
Current assets Blank Blank Blank
Cash and cash equivalents $63,800 $54,600 $56,500
Accounts receivable, less allowance for 39,600 48,900 50,200
doubtful accounts
Inventories 19,200 20,400 21,400
Total current assets 122,600 123,900 128,100
Property, plant, and equipment Blank Blank Blank
Land 260,000 160,000 160,000
Buildings and equipment 412,000 261,500 149,000
Total property, plant, and equipment 672,000 421,500 309,000
Less: accumulated depreciation 65,000 51,500 45,600
Net property, plant, and equipment 607,000 370,000 263,400
Total assets 729,600 493,900 391,500
Historical Balance Sheets (2 of 2)
Liabilities and Shareholders’ Equity
Table 8.2 (continued)
Assets December 31, 2018 December 31, 2017 December 31, 2016
Liabilities and shareholders’ equity Blank Blank Blank
Current liabilities
Accounts payable 30,200 46,900 50,400
Accrued expenses 9,900 8,000 4,100
Total current liabilities 40,100 54,900 54,500
Long-term liabilities Long-term debt 249,500 130,000 111,000
Long-term liabilities 249,500 130,000 111,000
Total liabilities 289,600 184,900 165,500
Shareholders’ equity Blank Blank Blank
Common stock (100,000 shares) 10,000 10,000 10,000
Retained earnings 430,000 299,000 216,000
Total shareholders’ equity 440,000 309,000 226,000
Total liabilities and shareholders’ equity 729,600 493,900 391,500
2. Balance Sheet: Is a snapshot of a company’s assets, liabilities, and owner’s equity at a specific
point in time.
Dec 31, 2018 Dec 31, 2017 Dec 31, 2016
Assets Cash 63,800 54,600 56,500
Accounts receivable 39,600 48,900 50,200
inventories 19,200 20,400 21,400
Land 260,000 160,000 160,000
Building & equipment 412,000 261,500 149,000
Less depreciation 65,000 51,500 45,600
Total assets 729,600 493,900 391,500
Liabilities Accounts payable 40,100 54,900 54,500
Long-term debt 249,500 130,000 111,000
Must
Total liabilities 289,600 184,900 165,500
equal
Shareholders equity Common Stock 10,000 10,000 10,000
Retained earnings 430,000 309,000 226,000
Total shareholders’ equity 440,000 309,000 226,000
Total Liabilities + Total shareholders’ equity 729,600 493,900 391,500

23
 When evaluating a balance sheet, the two primary questions are:
1. whether a firm has sufficient short-term assets
to cover its short-term debts and
There are two calculations that provide the answer
to the first question:
2. the working capital defined as its current assets
minus its current liabilities. This number
represents the amount of liquid assets the firm
has available.
3. Its current ratio, which equals the firm’s current
assets divided by its current liabilities, can tell us
more about the firm’s ability to pay its short-term
debts.
if the equation produces a negative number or if its current ratio,
which is current assets divided by current liabilities, is less than
one, for an extended period of time, it may be a cause of concern
for certain types of companies, indicating that they are struggling
to make ends meet and have to rely on borrowing
2. whether it is financially sound overall.
Computing a company’s overall debt ratio will
give us the answer to the second question, as
it is a means of assessing a firm’s overall
financial soundness. A company’s debt ratio is
computed by dividing its total debt by its total
assets.
When the ratio is decreasing this means the
company is relying less on debt to finance its
operations. In general, less debt creates more
freedom for the entrepreneurial firm in terms
of taking different actions.
24
Copyright © 2016, 2012, 2010 Pearson Education, Inc. All Rights Reserved.
Historical Statement of Cash Flows (1 of 2)
Table 8.3 Consolidated Statement of Cash Flows for New Venture Fitness Drinks, Inc.

Blank December 31, 2018 December 31, 2017

Cash flows from operating activities Blank Blank
Net income $131,000 $83,000
Additions (sources of cash) Blank Blank
Depreciation 13,500 5,900
Decreases in accounts receivable 9,300 1,300
Increase in accrued expenses 1,900 3,900
Decrease in inventory 1,200 1,000
Subtractions (uses of cash) Blank Blank
Decrease in accounts payable (16,700) (3,500)
Total adjustments 9,200 8,600
Net cash provided by operating activities 140,200 91,600
Cash flows from investing activities Blank Blank
Historical Statement of Cash Flows (2 of 2)
Table 8.3 (continued)

Blank December 31, 2018 December 31, 2017

Purchase of building and equipment (250,500) (112,500)

Net cash flows provided by investing activities (250,500) (112,500)

Cash flows from financing activities Blank Blank

Proceeds from increase in long-term debt 119,500 19,000

Net cash flows provided by financing activities 119,500 19,000

Increase in cash 9,200 (1,900)

Cash and cash equivalents at the beginning of each year 54,600 56,500

Cash and cash equivalents at the end of each year 63,800 54,600
3. Cash flow: Summarizes the changes in a firm’s cash position for a specified period of time and details why the
changes occurred.
December 31,2018 December 31,2017

A firm’s net income, taken from its income

statement, is the first line

If a firm allows the levels of either of these assets

to get too high, it may not be able to keep enough
cash on hand to meet its short-term obligations.

a decrease in accounts payable shows up as a

negative figure on the cash flow statement (in
parenthesis) because the firm used part of its cash
to reduce its accounts payable

It is funding its investment activities from a

combination of debt and earnings

This firm is steadily increasing its cash on hand.

It is accumulating cash that could be put to
work for a more productive purpose.
These numbers are taken from the first line in the
balance sheet

28
Ratio Analysis (1 of 2)

Ratio Analysis
◦ The most practical way to interpret or make sense of a firm’s
historical financial statements is through ratio analysis, as shown
in the next slide.
Comparing a Firm’s Financial Results to Industry Norms
◦ Comparing a firm’s financial results to industry norms helps a
firm determine how it stacks up against its competitors and if
there are any financial “red flags” requiring attention.
Historical Ratio Analysis (1 of 2)
Table 8.4 Ratio Analysis for New Venture Fitness Drinks, Inc.
Ratio Formula 2018 2017 2016
Profitability ratios: associate the amount of Blank Blank Blank Blank
income earned with the resources used to
generate it
• Return on assets ROA = net income/average total 21.4% 18.7% 14.7%
assetsa
• Return on equity ROE = net income/average 35.0% 31.0% 24.9%
shareholders’ equityb
• Profit margin Profit margin = net income/net 22.3% 17.9% 13.6%
sales
Liquidity ratios: measure the extent to which a Blank Blank Blank Blank
company can quickly liquidate assets to cover
short-term liabilities
• Current Current assets/current liabilities 3.06 2.26 2.35

• Quick Quick assets/current liabilities 2.58 1.89 1.96

Overall financial stability ratio: measures the Blank Blank Blank Blank
overall financial stability of a firm
• Debt Total debt/total assets 39.7% 37.4% 42.3%
• Debt to equity Total liabilities/owners’ equity 65.8% 59.8% 73.2%
• Ratio analysis: Depict relationships between items on a firm’s financial statements.
• An analysis of its financial ratios helps a firm determine whether it is meeting its financial objectives and how it
stacks up against industry peers.

Ratio Formula 2018 2017 2016

Profitability ratios Return on Assets Net income/average total assets 21.4% 18.7% 14.7%
Return on Equity Net income/average shareholders’ equity 35.0% 31.0% 24.9%
Profit Margin Net income/net sales 22.3% 17.9% 13.6%
Liquidity ratios Current Current assets/ current liabilities 3.06 2.26 2.35
Quick Quick assets/ current liabilities 2.58 1.89 1.96
Financial stability Debt Total debt/ total assets 39.7% 37.4% 42.3%
ratios
Debt to Equity Total liabilities/ owner’s equity 65.8% 59.8% 73.2%

31
Kamal is the owner of a digital photography. The
company has been profitable every year of its
existence.
• Its debt ratio (Total debt/ Total assets) is
currently 68 percent,
• its current ratio is 1.1 (Current assets/ current
liabilities),
• and its debt-to-equity ratio (Total liabilities/
Owner’s equity) is 72.2 percent.
Do these financial numbers cause any reason to be
concerned? Why or why not?
Copyright © 2016, 2012, 2010 Pearson Education, Inc. All Rights Reserved.
In general, many investors look for a company to have a debt
ratio between 0.3 and 0.6. From a pure risk perspective, debt
ratios of 0.4 or lower are considered better, while a debt ratio
of 0.6 or higher makes it more difficult to borrow money.
In general, a good current ratio is anything over 1, with 1.5 to
2 being the ideal. If this is the case, the company has more than
enough cash to meet its liabilities while using its capital
effectively.
The optimal debt-to-equity ratio will tend to vary widely by
industry. A ratio greater than 1 implies that the majority of the
assets are funded through debt. A ratio less than 1 implies
that the assets are financed mainly through equity. A lower
debt to equity ratio means the company primarily relies on
wholly-owned funds to leverage its finances.
Comparing a Firm’s Financial Results to Industry Norms:
• Comparing a firm’s financial results to industry norms helps a firm determine how
it stacks up against its competitors and if there are any financial “red flags”
requiring attention.
• This type of comparison works best for firms that are of similar size, so the results
should be interpreted with caution by new firms.

• Sometimes raw financial ratios that are not viewed in context are deceiving. For
example, a firm’s past three years’ income statements may show that it is
increasing its sales at a rate of 15 percent per year. This number may seem
impressive—until one learns that the industry in which the firm competes is
growing at a rate of 30 percent per year, showing that the firm is steadily losing
market share.

33
 Forecasts (1 of 4)

Forecasts
◦ The analysis of a firm’s historical financial statements are followed by
the preparation of forecasts.
◦ Forecasts are predictions of a firm’s future sales, expenses, income,
and capital expenditures.
◦ A firm’s forecasts provide the basis for its pro forma financial
statements.
◦ A well-developed set of pro forma financial statements helps a firm
create accurate budgets, build financial plans, and manage its finances
in a proactive rather than a reactive manner.
 Management process for…
Existing firms Start-ups

Assumptions sheet Assumptions sheet

• past performance, • estimate of sales
• its current • industry averages
circumstances, • or the experiences of
• and its future plans. similar start-ups

Ratio analysis Should be

applied after preparation of
historic financial statements
too

Copyright © 2016, 2012, 2010 Pearson Education, Inc. All Rights Reserved.
Forecasts (2 of 4)
Sales Forecast
◦ A sales forecast is a projection of a firm’s sales for a specified period (such as a year).
◦ It is the first forecast developed and is the basis for most of the other forecasts.
◦ A sales forecast for a new firm is based on a good-faith estimate of sales and on
industry averages or the experiences of similar start-ups.
completely new firm’s forecast should be preceded in its business plan by an
explanation of the sources of the numbers for the forecast and the assumptions
used to generate them. This explanation is called an assumptions sheet
◦ A sales forecast for an existing firm is based on (1) its record of past sales, (2) its
current production capacity and product demand, and (3) any factors that will affect
its future production capacity and product demand.

◦ If a company overestimates the demand for its products, it might get stuck with
excess inventory and spend too much on overhead. If it underestimates the demand
for its product, it might have to turn away business, and some of its potential
customers might get into the habit of buying other firms.
Forecasts (3 of 4)
Figure 8.3 Historical and Forecasted Annual Sales for New Venture Fitness
Drinks

Insert new Figure 8.3

1. Sales Forecast
• A sales forecast is a projection of a firm’s sales for a specified period (such as a year).
• It is the first forecast developed and is the basis for most of the other forecasts.
A sales forecast for an existing firm is A sales forecast for a new firm is based on
based on:
(1) its record of past sales, (1) a good-faith estimate of sales
(2) its current production capacity and product (2) on industry averages
demand (3) the experiences of similar start-ups.
(3) any factors that will affect its future product
capacity and product demand. For example, the assumptions sheet
for a new venture may say that its
forecasts are based on selling 500
units of its new product the first year,
1,000 units the second year, and
1,500 units the third year and that its
cost of goods sold will remain stable
(meaning that it will stay fixed at a
certain percentage of net sales) over
the three-year period.
38
First step is: forecasting sales… to do so: Example (1)
1. Calculate the percentage of increase in sales of
previous performance as in the example (1)
2. Multiply the percentage of increase in sales by the
actual sales of last year then add that to the actual
Increase in sales in 2017: (463,100 – 368,900) / 368,900 = 0.255
sales of the same year as in the example (2)
3. Calculate other increases according to any other Increase in sales in 2018: (586,600 - 463,100) / 463,100 = 0.267
factors as in the example (3)

Example (2): depending on past performance

586,600 x 26.7 % = 156,622 more in 2019
586,600 + 156,622 = 743,222 the initial forecast sales for 2019

Example (3): taking into consideration the new branch

The new branch will increase sales by another 50% of the
initial forecasted increase for 2019
156,622 x 0.50 = 78,311
586,600 + 156,622 + 78,311 = 821,533 the forecasted sales for 2019

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39
Forecasts (4 of 4)
Forecast of Costs of Sales and Other Items
◦ Once a firm has completed its sales forecast, it must forecast its
cost of sales (or cost of goods sold) and the other items on its
income statement.
◦ The most common way to do this is to use the percent-of-sales
method, which is a method for expressing each expense item as a
percentage of sales.
◦ If a firm determines that it can use the percent-of-sales method
and it follows the procedures described in the textbook, then the
net result is that each expense item on its income statement will
grow at the same rate as sales (with the exception of items that can
be individually forecast, such as depreciation).
 First step was: forecasting sales… refer to previous slides
Second step is: forecasting costs… to do so:
1. Calculate the average of costs of sales of previous
performance as in the example (1)
2. Multiply the percentage of costs of sales by the
forecasted sales for the next periods as in the
example (2)

Example (1) Example (2)

Costs of sales is calculated from numbers taken from 821,200 x 47.3%= 388,427 the forecasted costs for 2019
the income statement. 1,026,500 x 47.3%= 485,534 the forecasted costs for 2020

Costs of sales for 2017: 225500 / 463100 = 0.487

Costs of sales for 2018: 268900 / 586600 = 0.458 Costs of sales average for 2017 & 2018: (0.487 + 0.458) / 2 = 0.473
Copyright © 2016, 2012, 2010 Pearson Education, Inc. All Rights Reserved.
41
“Pizza maker” project
Per unit In a day In a month In a year Operating at 50% Operating at Operating at Operating at
(12 hours = (25 work (full capacity) capacity First year 65% capacity 80% capacity 80% capacity
2 shifts) days) (per month x 12) Second year Third year Fourth year
No. of Units 1 large
pizza 36 900 units 10,800 5,400 7,020 8,640 8,640

Sales price 4 JDs

4 x 36 = 3,600 JDs 43,200 JDs 21,600 JDs 28,080 JDs 34,560 JDs 34,560 JDs
144 JDs
Cost of Sales 1 JDs
36 JDs 900 JDs 10,800 JDs 5,400 JDs 7,020 JDs 8,640 JDs 8,640 JDs
Gross profit 4–1=
3 JDs 108 JDs 2,700 JDs 32,400 JDs 16,200 JDs 21,060 JDs 25,920 JDs 25,920 JDs
Operating
expenses
18,800 + (8,000 startup 18,800 + (8,000 startup 29,400 JDs 27,140 JDs 20,020 JDs
Operating costs) = 26800 JDs costs) = 26800
income
5,600 JDs -10,600 JDs -8,340 JDs -1,220 JDs 5,900JDs

Operating Per In a year Operating at 50% Operating at 65% Operating at 80% Operating at 80%
expenses mont (full capacity) capacity First year capacity Second capacity Third year capacity Fourth year If the fixed costs for the
h (per month x 12) year project during a year reach
Startup cost 8,000 18,800 JDs…
Payroll 1200 14,400 and the startup costs were
Rent 200 2,000 8,000 JDs…
Marketing 50 600
Utilities 50 600 • calculate the break-
Insurance 50 600 even point for the
18,800+ (8,000 startup 18,800 + 10,600 = 18,800 + 8,340 = 18,800 + 1,220 =
Other 50 600 costs) = 26800 JDs 29,400 JDs 27,140 JDS 20,020 JDS project for that year.
Total 1600 18,800+ (8,000 startup • when can the project
costs) = 26800 JDS cover up the startup
Copyright © 2016, 2012, 2010 Pearson Education, Inc. All Rights Reserved. costs? 42
3. break-even point
Is the point where total revenue received equals total costs associated with the sale of the product
The formula for break-even analysis:
For the “pizza maker” Project
If the fixed costs for the project during the year reach
Total fixed costs + (startup costs) 18,800 JDs and the start up cost is 8000, calculate the
(price per unit – average variable costs per unit) break-even point during that year.
26, 800/(4-1) = 8934 pizzas

If the total fixed cost associated with opening a new restaurant is $101,000 per year, the
average price for a fitness drink is $2.75, and the variable cost (or cost of goods sold) for
each drink is $1.10, then the break-even point for the new restaurant is as follows:

$101,000/($2.75 - $1.10) = 61,212 units

This number means that the new restaurant will have to sell 61,212 “units” per year to
“break even” at the current price of the drinks, or 170 fitness drink per day.

43
 Pro Forma Financial Statements Start-ups
Pro Forma Financial Statements
◦ Pro Forma Financial Statements: Are
projections for future periods based on
forecasts and are typically completed for two Assumptions sheet
to three years in the future. They are • estimate of sales
planning tools •
•
industry averages
or the experiences of
◦ A firm’s pro forma financial statements are similar start-ups

similar to its historical financial statements

except that they look forward rather than Planning tools
track the past.
◦ The preparation of pro forma financial
statements helps a firm rethink its strategies
and make adjustments if necessary.
◦ The preparation of pro forma financials is
also necessary if a firm is seeking funding or
financing.
Pro Forma Shows the projected financial results of the operations of a firm over a specific
Income Statement period.
The percentage used to forecast the increase in sales is used to prepare the projected income
statement

Pro Forma Shows a projected snapshot of a company’s assets, liabilities, and owner’s equity
Balance Sheet at a specific point in time.
how its activities will affect its ability to meet its short-term liabilities and how its finances will
evolve over time. It can also quickly show how much of a firm’s money will be tied up in
accounts receivable, inventory, and equipment. It is common for a new firm to invest the
majority of its cash in activities that fund its growth, such as property, plant, and equipment
purchases, rather than pay dividends.

Pro Forma Shows the projected flow of cash into

Statement of Cash flows and out of a company for a specific period.

45
 https://www.cbsnews.com/news/my-company-grew-too-fast-and-went-out-of-business/
Read for your own benefit… not
My Company Grew Too Fast -- and Went Out of Business required for exam
When I started Wise Acre Frozen Treats, no other company was making organic popsicles from unrefined sweeteners. Working out of a schoolhouse kitchen in March 2006, I developed my recipes using
honey and maple syrup. A year and a half in, I brought on my first employee, and then it really took off from there.
By 2008, we had 15 employees, a 3,000-square-foot manufacturing facility, and distribution to all of the natural foods stores and many major supermarket chains on the East Coast. Then we landed a contract
to distribute on the West Coast, too -- but we never got the chance to fill all the orders. By the end of the year, we'd gone bankrupt and I was unemployed.
A meteoric rise
After our first year, opportunities started coming up really fast. We won the "Most Innovative Product" award out of more than 2,000 products at a large food show called Expo East. From there, we lined up a
contract with a huge national distributor, United National Foods, and got freezer space in premier stores like Wegmans and Whole Foods.
Previously, we'd been filling orders for eight stores for a few hundred dollars each, but our first order from United National was something like $45,000 worth of product. It was a quantum leap.
The company's progress was right in line with my business plan's best-case scenario.
A run-in with the local billionaire
Once business took off, I knew I needed to raise more capital to cover our operating expenses, which included labor, equipment, ingredients, packaging materials, insurance, taxes, legal fees, design and
marketing, as well the lease on our building.
Local bankers gave us $300,000, split between a regular loan and an equipment loan. We also received $200,000 from an investment firm. But because we had so many orders to fill, I knew we really needed
about $1 million to keep us solvent.
We made a handshake deal for that amount with a local billionaire at the end of spring 2008. He told me, "I'll be able to make this happen really quickly," so I went back home and bought equipment -- even
though I didn't have the money to pay for it.
Weeks later, the bottom fell out of the economy. Our would-be investor was all wrapped up in the stock market decline and pulled out of our deal. That was the beginning of the end.
Investor issues
There were five or six months when I was constantly doing a mad dash between running the company and meeting with potential investors. The investors would always say, "We're looking for someone
making $2 million in revenue."
At that point, Wise Acre was making about $200,000. I'd ask them, "If we were making that much, why would I need you? I have a product that sells really well, no one else has it -- what else do I need to do?"
They all said, "We'd like to see what you can do without our money first."
It's a chicken-and-egg thing: If you're already really successful and you don't really need the money, they'll give it to you.
Why we failed
Our business plan indicated that it would be about two years from starting production to making a profit. But one of our biggest problems was that we didn't raise the money we needed before we hit
milestones like getting distribution throughout the East Coast. We went from eight stores to dozens, then hundreds, immediately. We were burning through about $30,000 a month at our peak, but we didn't
have the capital in place to back it up.
I also wish I'd hired people who were good at raising money. The people I did hire had good contacts, but they didn't have the background or experience to effectively raise the funds we needed. Even in that
economy, I could have raised the money if I'd had the right people on board from the start.
The aftermath
By the end of 2008, Wise Acre had gone out of business. Even though the orders were still coming in, we couldn't pay our bills. The $300,000 bank loan was in my name, and I had to declare bankruptcy. Now
the bank owns the product, the equipment and all of the trademarks.
To add insult to injury, I live in a remote area without many jobs, so I was unemployed for about a year. To go from being the boss of a big shop to being unemployed was really demoralizing. Now, thankfully, I
have a professional job, but it's not at the same level.
It was incredibly frustrating and depressing to have things end the way they did, but running my own company was a hell of an experience. It's important to stand behind a product that you believe in. A lot of it
is timing, and a lot of it is making your own luck.
Copyright © 2016, 2012, 2010 Pearson Education, Inc. All Rights Reserved.
Pro Forma Income Statements
Table 8.6 Pro Forma Income Statement for New Venture Fitness Drinks, Inc.
blank 2018 Actual 2017 Projected 2016 Projected
Net sales $586,600 $821,200 $1,026,500
Cost of sales 268,900 390,000 487,600
Gross profit 317,700 431,200 538,900
Operating expenses blank blank blank
Selling, general, and 117,800 205,300 256,600
administrative expenses
Depreciation 13,500 18,500 22,500
Operating income 186,400 207,400 259,800
Other income blank blank blank
Interest income 1,900 2,000 2,000
Interest expense (15,000) (17,500) (17,000)
Other income (expense), net 10,900 20,000 20,000
Income before income taxes 184,200 211,900 264,800
Income tax expense 53,200 63,600 79,400
Net income 131,000 148,300 185,400
Earnings per share 1.31 1.48 1.85
 Pro
Assets
Forma Balance Sheets (1 of 2)

Table 8.7 Pro Forma Balance Sheets for New Venture Fitness Drinks, Inc.
Assets December 31, 2018 Projected 2019 Projected 2020
Current assets blank blank blank
Cash and cash equivalents $63,800 $53,400 $80,200
Accounts receivable, less allowance for 39,600 57,500 71,900
doubtful accounts
Inventories 19,200 32,900 41,000
Total current assets 122,600 143,800 193,100
Property, plant, and equipment blank blank blank
Land 260,000 260,000 360,000
Buildings and equipment 412,000 512,000 687,000
Total property, plant, and equipment 672,000 772,000 1,047,000
Less: accumulated depreciation 65,000 83,500 106,000
Net property, plant, and equipment 607,000 688,500 941,000
Total assets 729,600 832,300 1,134,100
 Pro Forma Balance Sheets (2 of 2)
Table 8.7 (continued)
Assets December 31, 2018 Projected 2019 Projected 2020
Liabilities and shareholders’ equity blank blank blank
Current liabilities blank blank blank
Accounts payable 30,200 57,500 71,900
Accrued expenses 9,900 12,000 14,000
Total current liabilities 40,100 69,500 85,900
Long-term liabilities blank blank blank
Long-term debt 249,500 174,500 274,500
Total long-term liabilities 249,500 174,500 274,500
Total liabilities 289,600 244,000 360,400
Shareholders’ equity blank blank blank
Common stock (100,000 shares) 10,000 10,000 10,000
Retained earnings 430,000 578,300 763,700
Total shareholders’ equity 440,000 588,300 773,700
Total liabilities and shareholders’ equity 729,600 832,300 1,134,100
 Pro Forma Statement of Cash
Flows (1 of 2)
Operating Activities
Table 8.8 Pro Forma Statement of Cash Flows for New Venture Fitness Drinks, Inc.

blank December 31, 2018 Projected 2019 Projected 2020

Cash flows from operating activities blank blank blank

Net income $131,000 $148,300 $185,400

Changes in working capital blank blank blank
Depreciation 13,500 18,500 22,500

Increase (decrease) in accounts receivable 9,300 (17,900) (14,400)

Increase (decrease) in accrued expenses 1,900 2,100 2,000

Increase (decrease) in inventory 1,200 (13,700) (8,100)

Increase (decrease) in accounts payable (16,700) 27,300 14,400

Total adjustments 9,200 16,300 16,400

Net cash provided by operating activities 140,200 164,600 201,800

 Pro Forma Statement of Cash
Flows (2 of 2)
Investing Activities and Financing Activities
Table 8.8 (continued)

blank December 31, 2018 Projected 2019 Projected 2020

Cash flows from investing activities blank blank blank

Purchase of building and equipment (250,500) (100,000) (275,000)

Net cash flows provided by investing activities (250,500) (100,000) (275,000)
Cash flows from financing activities blank blank blank

Proceeds from increase in long-term debt 119,500 – 100,000

Principle reduction in long-term debt blank (75,000) blank

Net cash flows provided by financing activities blank blank blank

Increase in cash 9,200 (10,400) 26,800

Cash and cash equivalents at the beginning of 54,600 63,800 53,400
the year
Cash and cash equivalents at the end of the year 63,800 53,400 80,200
Ratio Analysis (2 of 2)
Ratio Analysis (On-going Analysis of Financial Results)

◦ The same financial ratios used to evaluate a firm’s historical

financial statements should be used to evaluate the pro forma
financial statements.

◦ This work is completed so the firm can get a sense of :

◦ how its projected financial performance compares to its past
performance
◦ and how its projected activities will affect its cash position
and its overall financial soundness.
Ratio Analysis Based on Historical and Pro-Forma
Financial Statements
Table 8.9 Ratio Analysis of Historical and Pro Forma Financial Statements for New
Venture Fitness Drinks, Inc.
Historical Historical Historical Projected Projected
Ratio 2016 2017 2018 2019 2020
Profitability ratios Blank Blank Blank Blank Blank
Return on assets 14.7% 18.7% 21.4% 19.0% 18.9%
Return on equity 24.9% 31.0% 35.0% 28.9% 27.2%
Profit margin 13.6% 17.9% 22.3% 18.1% 18.1%
Liquidity ratios Blank Blank Blank Blank Blank
Current 2.35 2.26 3.05 2.07 2.24
Quick 1.96 1.89 2.58 1.60 1.78
Overall financial stability ratios Blank Blank Blank Blank Blank
Debt 42.3% 37.4% 39.7% 29.3% 31.8%
Debt to equity 73.2% 59.8% 65.8% 41.5% 46.6%